Global Securities Markets: Navigating the World's Exchanges and OTC Markets

WHAT IS A CDS?

A CDS is in many ways similar to an insurance contract. In exchange for paying an annual premium, the CDS buyer (i.e., the protection buyer) is insured against losses caused by a credit event (e.g., a default) related to the debt of a specific reference entity (e.g., a company or a bank).

The analogy with an insurance contract stops here: The protection buyer does not need to own the underlying debt in order to be able to purchase the CDS. However, to be able to collect the “insurance” payment from the CDS seller (i.e., the protection seller) in case a credit event does occur, the protection buyer must deliver an equivalent amount of the debt (bonds or loans) of the reference entity to the protection seller.

What Is a Credit Event?

A credit event is an event that may trigger the exercise of a CDS contract. Typically, credit events include failure to pay (interest or principal when due), bankruptcy, or restructuring.

Why Have CDSs Been Singled Out as Particularly Risky?

Credit derivatives markets are built on products that bind together institutions and markets in ways that are difficult to understand and survey, both at the institutional and systemic level. CDSs are relatively small compared to other OTC derivatives markets, but they are particularly significant in terms of risk.

The CDS market is highly concentrated among a handful of banks. A failure of any of them can have severe implications for the CDS market and for financial markets as a whole, as the Lehman ...